Payments on Account Explained

After the prolonged good weather and an unthinkable football World Cup run, it’s hard to remember having had a better July in recent years. However, despite the distractions, this July still has at least one thing in common with Julys gone-by: the dreaded self-assessment payment on account deadline and all the worry that comes with it. In this month’s article, Walpole Dunn explores the purpose of the payment on account system; the calculations that underpin them; and the top tips to help you manage them.

The payments on account system

HMRC would no doubt claim that, as well as giving the public finances a much needed boost half-way through the year, the payments on account system also assists taxpayers in managing their tax liabilities and in levelling the playing field between those employed and those not. But, in reality, is the payments on account system simply a source of major financial concern, and do the employees taxed under PAYE have the advantage?

On the one hand, yes. Most of the employees paying under PAYE can relax, safe in the knowledge that the management of their tax liabilities is, in effect, taken out of their control. Their employer deducts their taxes for them and pays them to HMRC on their behalf. In some respects, it could be argued that this goes some way in reducing the psychological burden of tax, or even, for individuals whose only income is taxed this way, removing it altogether.

On the other hand, taxpayers paying under self-assessment do have a major advantage over those taxed under PAYE. Unlike PAYE taxation which deducts tax on an ‘as earned’ basis, in effect, the self-assessment systems provide users with a credit account with HMRC, affording them months’ worth of interest-free credit on their tax bill.

For example:

An employee at a web-design business earns £2,000 before tax in January 2017. Their employer will deduct tax in their monthly payroll under the PAYE system and pay it over to HMRC on the employee’s behalf, paying the employee the balancing figure. The next time this employee will pay tax on employment income is February 2017, when they are next paid.

A self-employed web designer earns £2,000 on a job in January 2017. They run their accounting period on a calendar year and so this income is included in their accounts to the year ended 31 December 2017, which falls into the 2017/18 tax year ending 5 April 2018. The tax due on the profits from the job in January 2017 is therefore due by 31 January 2019. Subject to the individual falling within the payments on account system, the next time they will pay tax is the following January.

The payments on account system was introduced to go some way in remedying this. It requires qualifying individuals to make early ‘deposits’ against their future tax bills, reducing the time between when the income is earned and the tax is paid.

Payments on account are split into two equal payments: one at 31 January, the time at which you are due to pay your previous years’ tax liability, and one at 31 July. These payments are then deducted from the taxpayer’s next tax bill, leaving either a smaller amount payable, known as the “balancing payment”, or an overpayment that they can reclaim.

So what does this practically mean for tax payers paying under self-assessment as opposed to PAYE?

It means that they receive their income gross of tax and are expected and required to manage the funding of their tax payments themselves from that gross income.

Now, if you consider that some taxpayers’ annual tax liabilities can run well into the thousands of pounds and mix that with our nation’s well-documented inability to save, living costs that are only going one way, and the inevitable mindset of “it’s in my bank account so I’ll spend it”, it’s no wonder that payments on account can prove so stressful for so many. Advantage PAYE earners?

The calculations underpinning your payments on account

In the first instance, payments on account are based on the taxpayer’s tax liability from the previous year. For the purposes of payments on account, income tax and class 4 national insurance (the national insurance due on trading profits) are taken in account, but capital gains tax and student loan payments are ignored, since it cannot be assumed that they will be relevant in the following year.

For example:

A taxpayer’s bill for the 2016/17 is £5,000, £1,000 of which is capital gains tax and the rest is income tax. Against this amount they have already made two payments on account of £1,300 each – one on 31 January 2017 and the other on 31 July 2017.

By 31 January 2018 (the deadline for the 2016/17 tax liability) the taxpayer must pay:

£2,400 balancing payment in respect of 2016/17 (i.e. the tax bill less the two payments on account); plus

£2,000, being the first payment on account of 2017/18 (equivalent to half of their 2016/17 income tax bill)

The second payment on account of £2,000 is payable by 31 July 2018.

If the taxpayer’s tax bill for 2017/18 is more than the £4,000 paid on account, they will need to make a ‘balancing payment’ in respect of that year by 31 January 2019.

In certain situations, payments on account aren’t necessary. The most common circumstances include if your total income tax and class 4 national insurance bill for the year is less than £1,000, or if more than 80% of your tax liability is paid ‘at source’, e.g. through PAYE.

It’s also possible to make a claim to reduce your payments on account if you have a valid reason for the tax not being due, such as your income has dropped in the subsequent year. However, it is worth noting that HMRC will charge interest on underpayments if they can see that payments on account had been excessively reduced.

Payments on account are only ever based on your prior year’s tax liability. If your tax liability for a subsequent year has increased on the previous and your payments on account haven’t covered the higher amount, HMRC won’t punish you for the resulting underpayment.

Top tips for managing payments on account

For many, payments on account are unavoidable, and so to ensure that they don’t become a stressful, financial burden, we recommend the following top tips for managing payments on account:

Saving

It may sound obvious, but putting some money aside each month is the best way of making sure that payments on account don’t become a nasty, unaffordable surprise. Your accountant should have informed you of the amounts that you are due to pay well before the payment deadline and so setting a savings budget early on is the ultimate way of managing the system.

Remember that the first year is the hardest

Payments on account are cyclical in nature. Once you have been in the system for a number of years, the burden of “extra tax” should only have an effect if your income continues to rise or you have an odd year where income has spiked. In other cases, if the theory of payments on account works, you shouldn’t be left with any balancing payments at the end of the cycle and so payments on account can become a useful way of simply splitting your tax liability into two more manageable payments.

However, it’s worth remembering that the first year that you fall into the system will always be the most financially expensive. If you haven’t made payments on account before, you will be paying both the full amount of your tax liability, plus 50% of next years’. For that reason it is recommended that savers account for 1.5 times their estimated tax bill in that first year.

Get your tax return done early

Not only does it relieve the stress of a late January rush to prepare your return early, but it can also help with cashflow.

In the absence of accurate figures, payments on account will always be based on the prior year’s tax liability. However, if you are able to prove that your tax liability is due to decrease by submitting your tax return prior to your second payment on account due in July, you can make a claim to reduce the default payments without fearing financial recourse from HMRC.

If you’re interested in understanding more about your payments on account, or your tax return and liabilities in general, contact us today for an initial, free-of-charge meeting.